US sues S&P over ratings

WASHINGTON -- A U.S. Justice Department lawsuit against McGraw-Hill Cos. and its Standard & Poor’s unit seeks to punish conduct central to the worst financial crisis since the Great Depression, Attorney General Eric Holder said.

The “egregious” conduct “goes to the very heart of the recent financial crisis,” Holder said Tuesday at a news conference in Washington.

The complaint “is an important step forward in our ongoing efforts to investigate and punish the conduct that is believed to have contributed to the worst economic crisis in recent history.”

The U.S. Justice Department filed a civil complaint Monday in in Los Angeles accusing McGraw-Hill (NYSE: MHP) and S&P of three types of fraud, the first federal case against a ratings company for grades related to the credit crisis.

Attorneys general from six states and the District of Columbia joined Holder on Tuesday and additional states were expected to file also, he said.

McGraw-Hill tumbled the most in 25 years Monday, when the company said it expected the lawsuit.

Three years

The Justice Department has been probing the company for more than three years, according to a person familiar with the process who asked for anonymity.

Over the course of the investigation, the company turned over more than 20 million pages of documents, which included a large number of emails between the firm’s employees, the person said.

Those emails, along with questions about the models used by the company to rate bonds, have become the basis for the department’s lawsuit.

S&P issued credit ratings on more than $2.8 trillion of residential mortgage-backed securities (RMBS) and about $1.2 trillion of collateralized debt obligations (CDO) from September 2004 through October 2007, according to the complaint.

S&P downplayed the risks on portions of the securities to gain more business from the investment banks that issued them, the U.S. said.

“It’s going to be a tricky time for rating agencies,” Fred Ponzo, a capital markets analyst at Greyspark Partners in London, said. “S&P is probably just the first to face the music.”

Company comment

The company denied any wrongdoing.

“Claims that we deliberately kept ratings high when we knew they should be lower are simply not true. We will vigorously defend S&P against these unwarranted claims,” said Catherine Mathis, a company spokeswoman.

“The fact is that S&P’s ratings were based on the same subprime mortgage data available to the rest of the market -- including U.S. government officials who in 2007 publicly stated that problems in the subprime market appeared to be contained,” she said.

Fitch Ratings has “no reason to believe” it faces a similar lawsuit, said Dan Noonan, a spokesman in New York for the third-largest credit-rating firm.

S&P stripped the U.S. of its AAA credit rating on Aug. 5, 2011, and said the world’s largest economy was no longer the safest of borrowers.

The downgrade failed to dissuade investors as dollar-denominated assets have appreciated.

Yields surge

Under the Financial Institutions Reform, Recovery and Enforcement Act of 1989, the U.S. seeks civil penalties of as much as $1.1 million for each violation.

Settlement talks broke down after the government sought a fine of more than $1 billion and an admission of wrongdoing from S&P, the New York Times reported.

That amount would wipe out the profits of McGraw-Hill for an entire year, the newspaper said.

Ratings firms have faced criticism from U.S. lawmakers over how they granted top grades to securities that packaged home loans from the riskiest borrowers, leading to a credit seizure, starting in 2007, that sent the world’s largest economy into its longest recession since 1933 as defaults soared and home values plummeted.

Market share

“S&P’s desire for increased revenue and market share in the RMBS and CDO ratings markets led S&P to downplay and disregard the true extent of the credit risks,” the United States said.

McGraw-Hill’s net income climbed 15 percent to $1.01 billion in 2007, only to decline more than 20 percent the following year.

According to the U.S. complaint, S&P falsely represented to investors that its credit ratings were objective, independent and uninfluenced by any conflicts of interests.

The company bent rating models to suit its business needs to the extent that one CDO analyst commented that loosening the measure of default risk for a certain security in 2006 “resulted in a loophole in S&P’s rating model big enough to drive a Mack truck through,” the U.S. said.

Banks create CDOs by bundling bonds or loans into securities of varying risk and return.

They pay ratings companies for the grades, which investors may use to meet regulatory requirements.

Lucrative business

Analysts at New York-based S&P, Moody’s Investors Service (NYSE: MCO) and Fitch, majority-owned by Fimalac SA of Paris, were pressured to give their stamp of approval to complex investments in a “race to the bottom” to win lucrative business from Wall Street banks, the U.S. Senate Permanent Subcommittee on Investigations said in an April 2011 report.

The Justice Department cites emails from S&P employees discussing the need to modify ratings criteria to win business after the company’s grades were more conservative than competitors.

“Losing one or even several deals due to criteria issues, but this is so significant that it could have an impact on future deals,” one analyst said in a May 2004 email cited in the lawsuit. “There’s no way we can get back on this one but we need to address this now in preparation for future deals.”

Bank losses

The credit-grading business was targeted by lawmakers in the 2010 Dodd-Frank Act after the collapse of top-ranked mortgage-backed securities contributed to $2.1 trillion in losses at the world’s largest banks.

Reports from the Senate panel, along with the Financial Crisis Inquiry Commission, cited failures of the companies as a reason for the financial crisis.

While the 18-month recession ended in June 2009, with the global economy contracting 2.4 percent that year, the U.S. has yet to recover 3.23 million of the 8.74 million jobs that were lost.

The unemployment rate last month was 7.9 percent, compared with 5 percent in January 2008.

State suits

New York Attorney General Eric Schneiderman, who is helping to lead a state-federal group probing misconduct in the bundling of mortgage loans into securities, is separately investigating S&P over its ratings on mortgage bonds, according to a person familiar with the matter who asked not to be identified because the investigation hasn’t been made public.

Attorneys general from at least two U.S. states have filed claims against S&P challenging its method of rating mortgage- backed securities.

Illinois Attorney General Lisa Madigan, who sued S&P more than a year ago, commended Holder and her state colleagues in a statement Tuesday.

“Standard & Poor’s was a trigger for the destruction of our economy,” Madigan said. “While the big banks and lenders built mortgage-backed bombs, it was S&P’s faulty ratings that detonated them.”

In 2009, then-Ohio Attorney General Richard Cordray sued S&P, Moody’s and Fitch at the U.S. court in Columbus, accusing the firms of issuing faulty ratings that caused five public employee pension funds, on whose behalf he sued, to buy money- losing investments.

U.S. District Judge James L. Graham threw out the case in September 2011, ruling the ratings were “predictive opinions,” and that absent specific allegations of intent to defraud, the firms could not be held liable.